Bond supply and demand both affect inflation. The active issuance of bonds is inflationary, and demand for bonds, decreasing the supply, tends to lessen inflation. This is one reason the Federal Reserve uses the bond market to manage inflation. Through accommodating monetary policy, the Fed encourages bond issuance, and through restrictive monetary policy, the Fed discourages bond issuance to prevent inflation.
When the amount of money in the system rises to a point where there is an over abundance of money available to buy goods and services, the prices of those goods and services rise as goods go to the highest bidder - this is inflation. The term refers to the inflated volume of money seeking goods and services, not to the resultant rise in prices. Increasing bond supply creates more money in the system, and results in inflation and high interest rates.
When interest rates are low, companies are induced, by the low borrowing costs, to issue bonds. As more companies borrow in the bond market, the supply of bonds increases. This raises competition in the markets for investor dollars, which means that interest rates tend to rise to attract investors. As the economy recovers from recession and business booms, companies need more financing for their expansion and operations. They continue to issue bonds until the expense of borrowing at high interest rates prevents additional borrowing.
The additional supply of bonds creates more upward pressure on interest rates and inflation. Bond demand rises in reaction to inflation because investors seek higher investment returns to offset the effects of inflation. As interest rates rise to attract investors, it becomes expensive for companies to borrow in the markets, and the supply of bonds starts to shrink. Investor demand for bonds continues to grow, attracted by the high rates, and this further lightens the supply and lowers interest rates.
When the economy is booming the Fed adopts a restrictive monetary policy to keep inflation im check, which includes raising interest rates and removing money from the system. High interest rates discourage borrowing, but encourages the buying of bonds as investments rise. Increased demand for bond investments tends to lower interest rates -- the economy moves into recession, the money supply contracts and inflation diminishes. To recover from recession, the Fed lowers interest rates to induce corporate borrowing, which results in an increased supply of bonds.
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